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How Does Interest Work?

Budget and Save

Credit cards, and savings rates, and interest, Oh My!

Woman using calculator to calculate interest

There are several terms used in the financial industry. One of these terms is interest. Interest can be assessed (or charged), or earned. Savings accounts, Money Market accounts, and some checking accounts may earn interest. Credit cards and other Loans assess interest. Interest on loan accounts is also known as a finance charge.

Interest on Loans

Interest on loans or credit cards is calculated by multiplying the rate (APR), by the applicable balance. On a credit card, that can be based on any remaining balance at the end of your statement cycle, or on certain types of card transactions, such as cash advances, or balance transfers. These interest rates may vary based on the particular transaction type.

When you make a purchase with your credit card, the amount of the purchase is in essence borrowed from your card provider. When your credit card statement cycles, you will receive a bill that shows your credit card activity. This will include the actual transactions, and any fees or interest. Interest will vary month to month based on card activity.

The interest rate, sometimes also referred as the Annual Percentage Rate (APR) is used to calculate the interest or finance charge. The higher the interest rate, the more finance charges your loan will assess.

The interest rate may be determined based on several financial variables, including the index rate, the lender’s policies, and your own credit history. Credit cards are competitive, so terms and conditions may vary.

Loans—personal or mortgage— usually have a set payment per month. The interest is a portion of that payment amount. The amount of interest on a loan will decrease as you make payments.

Interest on Deposit Accounts

Interest may also apply to Deposit Accounts (such as Savings Accounts, Money Market Account, Certificates of Deposit, and some Checking Accounts). In this case, interest is working in your favor and is earned on your balance. For example, when you open an interest-bearing account (such as a savings account), you will receive an Annual Percentage Yield (APY) that will be paid to you based on the terms of the account.

Paying down loans and credit cards earlier can help reduce the amount of interest you pay. Growing your savings can help you earn more interest.

 

Sources:

What is Interest, The Balance
Indexed Rate, Investopedia

 

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